European companies under-promised and over-delivered on earnings this year and last, and that cautious managing of profit expectations risks backfiring in 2006 as analysts discount warnings about slowing growth.
Europe's third-quarter reporting season is now winding down, having again topped forecasts and helping stock indexes hit their highest levels in more than 3-1/2 years this week.
"We've still got pretty robust earnings, but looking ahead we do think the results this year have caused analysts to be too optimistic going into 2006," said Mark Precious, global equity strategist at UBS.
Analysts currently expect earnings growth of around 21 percent for 2005, having raised expectations from 10 percent at the start of the year.
That situation is unusual as more often analysts spend the year trimming overly optimistic expectations - a pattern some strategists see re-emerging in 2006.
Morgan Stanley worries that stalling US house prices will prompt consumers to curtail spending, slowing the global economy and limiting European company profits growth to just 4 percent next year.
"We think disappointments are likely on margins," said Morgan Stanley's co-head of European equity strategy, Ben Funnell, noting that some 79 percent of European companies are currently expected to improve their margins from already record levels.
VALUATIONS SUPPORT Despite healthy gains this year, few people see European stocks as expensive given that share price gains have only kept pace with earnings improvements.
The broad DJ Stoxx 600 Index is up an impressive near 20 percent so far this year, lagging the blockbuster 30 percent return in Japan's Nikkei but comfortably beating the Standard & Poor's 500's rally of less than 5 percent.
That means that European stocks trading at price to earnings ratio 12.8 times expected 2006 profits seem pretty good value - - both historically and against their global peers.
But the problem is that such reasonable valuations are reliant on companies achieving the near 10 percent earnings growth analysts expect next year.
Along with margins already near record highs, rising interest rates and the prospect of slowing global growth have already prompted analysts to start scaling back 2006 forecasts. Consensus forecasts for 2006 earnings per share growth have slipped to 8.9 percent from a peak above 11 percent expected earlier this year, according to earnings tracking firm FactSet.
FactSet vice president Bobby Rakhit said sectors likely to benefit from an increase in capital spending such as technology and industrial goods were expected to post the biggest rise in earnings, both around 17 percent.
"If you look at the consumer goods sector, they're expecting 11 percent next year and that's where the weakness could come from," Rakhit said, also highlighting expected media earnings growth of 14.4 percent and autos at 13 percent as potential risk areas.
KEEP THE FAITH Not everyone is fretting about the earnings outlook however.
Bernd Meyer, European equity strategist at Deutsche Bank, acknowledges that forecast earnings for next year are above the long-term trend but argues not to the extent seen in the two previous peaks in earnings growth.
Margins should be protected by subdued wage pressure and forecasts for still-solid global growth, said Meyer, who expects single-digit equity market gains in Europe next year.
"As long as global growth remains constant, the earnings growth that is expected by consensus...looks reasonable and is not at risk. That would mean I have no fear that we are running into a period of massive downgrades in the next 6 months."
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